Factor Markets: Wages, Rent, Interest and Profit
This domain explains how incomes are determined. It tests the derived nature of factor demand, the marginal revenue product rule, and the distinct theories behind wages, rent, interest and profit, with applications to Cameroon's large informal labour market.
Demand for factors
- Factor demand is derived from demand for the output and depends on the factor's productivity and the product price.
- A firm hires until marginal revenue product equals marginal factor cost. In a competitive labour market marginal factor cost equals the wage, so employment stops where MRP equals the wage.
- The MRP curve is the firm's demand curve for labour and shifts when productivity or output price changes.
Labour supply and wages
- Higher wages make leisure expensive (substitution effect) but raise real income (income effect); the income effect can produce a backward-bending supply curve.
- Wage differences reflect human capital, compensating differentials, union bargaining, monopsony power and labour immobility.
- A monopsonist sets employment where MRP equals marginal factor cost but pays the wage from the supply curve, below MRP; a minimum wage set at the competitive level can raise both pay and employment in this case.
- In Cameroon the SMIG, the guaranteed interprofessional minimum wage, sets a floor in the formal sector, while most workers are in the informal sector where wages are set by bargaining and marginal product.
Rent, interest and profit
- Economic rent is payment above transfer earnings, the sum needed to keep a factor in its present use; land with fixed supply earns pure rent.
- Interest is the price of loanable funds and the reward for waiting; the loanable-funds and liquidity-preference theories explain its level. Real interest equals nominal interest minus inflation.
- Normal profit is the opportunity cost of entrepreneurship; supernormal profit rewards risk-bearing, innovation and market power.
Worked example
A firm's fifth worker produces 20 units sold at 500 XAF each; the sixth produces 12 units.
- MRP of the fifth = 20 x 500 = 10,000 XAF; of the sixth = 12 x 500 = 6,000 XAF.
- If the wage is 8,000 XAF, the firm hires five workers and stops, since the sixth would add less than the wage.
- If the output price rises to 800 XAF, the sixth worker's MRP becomes 9,600 XAF and is hired, illustrating that labour demand shifts with product demand.
Traps that cost marks
- Treating marginal product as marginal revenue product, which mixes physical units with money.
- Saying labour demand depends only on the wage; productivity and output price matter.
- Claiming a minimum wage always destroys jobs; with monopsony it can expand employment.
- Confusing economic rent with rent paid for housing, or interest with profit.